Financial transactions tax

A financial transactions tax (FTT) is a tax imposed on financial transactions. It is aimed at reducing the trade of short-term financial instruments that speculate on the demand price of capital assets to attain financial gains. The goal of the FTT is to lengthen the ownership of financial assets, to reduce both the volatility of their prices and financial instability in the whole economic system. It should be a small tax, with negligible burden on asset holders who provide liquidity to financial markets but that should increase trans- action costs for investors who trade financial instruments for the sole purpose of making financial gains.

Speculation in financial markets is linked to non-ergodic systems, where an unknown and unpredictable future creates uncertainty with respect to prospective returns on investment. Such speculation is not neutralized by capital markets granting liquidity to non-liquid assets with the intention to calm down investors' "nerves and makes [them] much more willing to run a risk" (Keynes, 1936, p. 160). Indeed, Keynes's arguments are that the demand price of investment is based on psychological conventions, with no real anchors, subject to high volatility that induces a casino-type of activity with big financial gains (and losses), irrespective of economic fundamentals. This behaviour dominates in highly organized capital markets whose main characteristic is that financial transactions are almost costless.

In this framework, Keynes (1936, p. 160) argued that "[t]he introduction of a substan- tial government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the United States". Its objective is to make it less accessible and more expensive for the professional investors to trade financial instruments for the sake of price differentials. In other words, an FTT aims to curb financial speculation.

The huge financial imbalances resulting from the breakdown of the Bretton Woods regime in 1972-73 revived the debate over an FTT. Tobin (1974) suggested the adoption of a tax aimed at limiting speculative transactions on foreign-exchange markets (see Dimand and Dore, 2000, p. 516). Yet Tobin's proposal was different from Keynes's, as it affected all foreign-exchange transactions, ignoring the differences between speculative, trade and service flows, and concerned all types of financial instruments (ibid., p. 518). Grabel (2003, p. 325), following Tobin's definition, referred to this tax as a "modest ad- valorem tax on all spot transactions in foreign exchange", which was amended by Tobin (1996, p. xv) to encompass forward and swap transactions as well.

Through history, there have been different versions of FTTs adopted by various coun- tries. An FTT was first adopted in Britain in 1694 as a charging stamp duty on equity purchases, and, as recently as 14 February 2013, 11 European Union member countries announced the decision to impose an FTT on a variety of financial market transactions within and across their borders.

Mainstream economists oppose the FTT on the basis that speculation stabilizes financial markets, because it creates a process of riskless arbitrage that leads to the deter- mination of the true prices of financial securities. This view was developed notably by Friedman (1953) and strengthened by the efficient-market hypothesis. Heterodox econo- mists have criticized this position in various ways. Erturk (2006), for example, has ques- tioned the existence of true prices and, more importantly, limitless arbitrage processes.

Heterodox economists, however, are not unified in their support of an FTT. For instance, Davidson (1997, 1998) argues that, rather than decreasing instability, an FTT à la Tobin amplifies it, by reducing financial deepness in the market. Grabel (2003) consid- ers that it is not an effective means to reduce fragility risks, since the amount of an FTT is low in relation to the expected profits associated with financial speculation and it does not prevent herding behaviour. Particularly, an FTT is unable to raise transaction costs sufficiently without drying up financial market liquidity. Further, financial transactions are better explained in terms of bandwagon consensus or irrational exuberance, which can only be limited by market makers or directly through forbidding capital movements for speculative purposes. An FTT "may inflict greater damage on international trading in goods and services and service and arbitrage activities" (Davidson, 1998, p. 650) without affecting speculation.

Other heterodox economists reach an opposite conclusion. Arestis and Sawyer (1997) argue that higher volumes of financial transactions amplify and deepen capital markets as well as their volatility. Since an FTT increases their trade costs, it can partially curb speculation. As they explain, "in organized markets where transaction costs are minimal, the unknowability of the long-term future will cause speculation to dominate enterprise, and thickness of the market and volatility will both be effects of this. Thus the argument is not that one causes the other but that both are symptoms of pathological tendencies in financial markets" (ibid., p. 754).

More importantly, some economists argue that an FTT is a means of collecting significant government revenues, which is opposed by free-market economists and globalization-prone policy makers. Also, supporters of an FTT argue that the trading of financial assets does not directly increase the flows of goods and services, as such trading is a form of unproductive activity in the sense of Bhagwati (1982): financial transactions "may be privately profitable but do not directly increase the flow of goods and services" (Pollin et al., 2003, p. 530). In this respect, Erturk (2006, p. 76) argues that an FTT can "reduce the time horizon at which the price deviation begins to exert a negative influence on the elasticity of expectations and alters trade belief about risk characteristics of the market in which it is imposed". Hence, an FTT can "slow down traders' speed of reaction and lower their elasticity of future price reactions expectations with respect to current price changes" (ibid., p. 77), or can reduce speculation when the elasticity of expectations is greater than one. Arestis and Sawyer (1997, p. 760) maintain that "[a] rise in price gen- erates a larger rise in expected price, leading to increased demand now in anticipation of higher future prices, thereby exacerbating the rise in price. [. . .] A transaction tax would be expected to reduce substantially short-term dealing".

The FTT is a controversial issue even among those who argue that financial transac- tions are a source of profit, which does not provide finance for productive activities to increase real income. The question that has still to be addressed is whether an FTT can be converted into a device that would deter capital mobility. From the above arguments it can be argued that a negligible tax rate will neither reduce speculation nor stabilize financial market transactions but definitively will force rentiers to part with a portion of their returns.

See also:

Asset price inflation; Bretton Woods regime; Efficient markets theory; Financial crisis; Financial deregulation; Financial instability; Tobin tax.